How can Accounting Basis Impact your Business Decisions?
To make informed financial decisions for your business, you not only need to know the costs and benefits involved, but also your business’s current financial position, operating results, and cash flows. The Balance Sheet, Profit and Loss Statement, and Statement of Cash Flows reflect the financial state of your business and its operations. How these financial statements are presented depends upon your accounting basis, the method you use to record your business’s financial transactions.
The two main options are cash and accrual, and the significant difference is timing. With cash-basis accounting you record revenues when cash is received and expenses when cash is paid. Conversely, with accrual accounting revenues and expenses are recorded when earned and incurred, respectively. For example, if your business sells Product X for $100 and purchases the materials to make Product X on account for $50 at year-end in December 2017, then in January 2018 receives payment for the sale of Product X as well as pays the bill for the materials used, your business’ profits are going to differ under the two accounting methods. With cash-basis you would record the revenue on the sale for Product X and the expense for the materials in January when they are paid, while under the accrual method both would be recorded in December when earned and incurred.
Why does this timing matter to your business? It matters because of the matching principle, which means revenues should be matched to the expenses used to generate them. The matching principle can only occur with accrual accounting and without it you won’t get an accurate picture of what your business profits truly are. Revising the example above, instead of receiving payment for the sale in January, let’s say you received it at the time of sale in December. With cash-basis you are now recording the revenue in December and the expense used to generate the revenue in January, while with accrual you are still recording both in December. This means two things using cash-basis: 1) Your business revenue, and therefore your profits, are going to be higher in December and lower in January and 2) your profits for the 2017 will not include all of the relevant costs. If it looks like your business is making a profit when in reality, it’s making a loss because of the timing of recorded transactions, the decisions you make, and their consequences, will be affected.
While cash-basis accounting may be easier to apply and understand, accrual-basis accounting is generally accepted and preferred, and is really going to give you a better understanding of how well your business is doing financially. This in turn will help you make better decisions for your business.
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